Key findings

The US dollar continues to dominate world financial markets, with the euro a clear second.

China has accelerated efforts to reduce reliance on the dollar and boost foreign investment.

Geopolitical shifts, changes in energy market dynamics, structural shifts in China, and a dollar down cycle, could see de-dollarisation gather pace over the next few years, thereby eroding the exorbitant privilege of the US.

Scenario one anticipates full renminbi internationalisation, in which China's capital account fully opens over the next decade.

Scenario two looks at renminbi regionalisation, in which rising renminbi use is concentrated in emerging Asia.

Scenario three involves a reduced role for the dollar, which ultimately lowers US living standards.

The emergence of a genuinely multipolar world will have a profound impact on markets and portfolios.

The US dollar has enjoyed a dominant position since the end of the second world war. By some measures it is even stronger than a decade earlier. Despite America’s twin deficits, rising national debt levels, a turbulent domestic political environment and disruptive foreign policy, dollar use remains exceptionally wide and deep. Meanwhile, erstwhile rivals like the euro and renminbi have seen adoption slow.

Why there is no alternative to the dollar on the world stage:

1

Liquidity. The US remains the largest economy in nominal terms, meaning the supply of dollars and dollar-denominated assets is large enough to support the demands of global trade and finance.

2

Inertia. Many businesses in non-dollar countries invoice in dollars and are happy to deal in it regardless of the price. Effectively, they ‘think’ in dollars. Exporting firms prefer to keep prices stable relative to international competitors and also use imported inputs priced in dollars in production.1

3

Trust. The dollar is a viewed as a ‘safe-haven’ currency. It tends to appreciate during times of stress, which makes holding dollars attractive in normal times as well.

4

Lender of last resort. The US Federal Reserve is ready to assume a global role. It served as a backstop provider of dollars during the global financial crisis by pursuing swaps with fourteen central banks, including four in emerging markets.2 This contrasted sharply with the European Central Bank which in 2008 provided only limited assistance to the central banks of two EU countries, namely Poland and Hungary.3

Why de-dollarisation could be the story of the next cycle

Geopolitical shifts

2018 was potentially a watershed year in which countries in the path of sanctions, like Russia, Iran and to some extent China and the EU, began to accelerate ways to protect themselves from the consequences of using the dollar. President Trump’s sanctions are a proximate but not an ultimate cause for the shift. As European Commission president Jean-Claude Juncker put it, “it is absurd, ridiculous, that European companies buy European planes in dollars instead of euro.”4

Meanwhile, emerging Asian economies are always looking for ways to reduce the boom-and-bust cycle associated with the dollar, and they may get that opportunity as trade in Asia becomes less dependent on the US. Currently, for instance, a 10% US dollar appreciation takes about 1.5 percentage points off GDP growth in emerging market economies.5 Such countries therefore may find it to their advantage to sign swap agreements with the Chinese central bank and conduct trade in a currency like the renminbi, which increasingly reflects their trade patterns.

Structural shifts in China

China’s current account surplus has been on a downward trend since it touched 10% in 2007, driven by investment growth, currency appreciation, weak demand in advanced economies, and recently, a widening services deficit.6 But the big story is a shrinking of China’s working age population, which will ultimately have a negative impact on domestic savings. It is not impossible to foresee that by the mid-2020s, China could indeed be consistently running a current account deficit, implying a need to sell foreign assets or borrow from abroad. China would naturally prefer to borrow abroad in its own currency than incur foreign debt. To that end, recent Chinese initiatives to reduce reliance on the dollar include the China-led Asian Infrastructure Investment Bank, the launch of petroyuan oil futures on the Shanghai International Energy Exchange, as well as Belt and Road and the Made in China 2025 strategy.

Growth in Asia is becoming less dependent on the USPercentage of East Asia ex-China value added by final export destination

Source: OCED, 2015

Changes in energy market dynamics

Oil is a key commodity in the de-dollarisation process. One reason for the US dollar’s historical dominance is the US-Saudi settlement in the 1970s to invoice oil in petrodollars, which underpinned a dollar-based network of trade and finance. Yet today, China has overtaken the US as the world’s largest importer of crude oil, driven in part by the rise in US domestic oil production over the last ten years. It is the resulting Chinese trade deficit from oil imports that provides the impetus for de-dollarisation, since China would prefer to settle its trade bill in renminbi if possible. Oil companies in Russia, Iran and Venezuela have already begun accepting yuan as payment for Chinese imports, and were Saudi Arabia to follow, that would have a substantial impact.

The new crude buyers on the block

Source: BP, 2017

A dollar down cycle

Finally, there is a cyclical component to timing de-dollarisation. After spending six of the last seven calendar years on the up, another dollar down cycle may begin this year. Expensive fundamental valuations and poor technicals, which include significant foreign ownership and waning cash repatriation by US companies, will likely undermine support for the dollar. Given the historical lags between the dollar’s market price behaviour and current account and budget deficits, the dollar could fall materially in less than two years. Of course, interest rate differentials are still in favour of the dollar, and while that may change as the European Central Bank and the Bank of Japan normalise policy, there is also every chance that it is US rates that converge lower.

US twin deficits are a leading indicator of dollar weakness

Source: Source: Investec Asset Management, 2018

What will the next global currency shift look like?

The emergence of a genuinely multipolar world will have a profound impact on markets and portfolios. Although this is likely to be a gradual process, it can also happen overnight. The US abandonment of dollar-gold convertibility in 1971, or, before that, sterling’s departure from the gold standard in 1931, was initially far-fetched, then plausible, then inevitable. In both cases, the potential strategic investment implications are significant. After seven years of a dollar up cycle and a de-rating in emerging market assets, investors should be aware that the nature of the opportunity unfolding could be structural rather than purely cyclical.

Given the uncertainties of a currency transition, we explore three scenarios and their investment implications.

1. A new global currency

Scenario one – a new global currency

This scenario anticipates full renminbi internationalisation, a process that would see China fully opening its capital account over the next decade and integrating its financial system into the existing monetary framework. For now, China’s liberalisation efforts are largely focused on allowing foreign money into China more easily rather than permitting Chinese capital flows abroad. But ultimately, there will be vast flows in both directions. To anticipate the size of these flows, we update a Bank of England thought experiment from 2013 that assumes: China’s financial openness converges with other rich countries, catch-up growth in China continues, and there is a continued decline in home bias among Chinese consumers. On that basis, we estimate that China’s average of external assets and liabilities will rise from 8% of world output to 17% by 2030, impacting nearly every asset in the world.7

Investment implications for scenario one

If China’s financial walls are lifted, its vast pool of savings will participate in global capital markets, boosting global liquidity.

For Chinese investors there is an opportunity for further geographical diversification and improved domestic asset allocations. The current split between equity and fixed income in China’s private sector portfolio assets will likely increase from the current 59-41% to something closer to the United States’ 72-28%. Moreover, Chinese capital market liberalisation is also a clear opportunity for foreign investors to diversify portfolios. For instance, Chinese equities have less than half the correlation to the rest of the world compared to other major indices. There will also be opportunities in the synchronisation of the Chinese system with the rest of the world. A situation like 2018 where Chinese fixed income generated 7-10% while US government bond returns were negative, becomes less likely. Finally, easing capital controls under the current conditions of financial repression would improve the return on household savings as Chinese citizens would have more investment options.

2. Managed internationalisation

Scenario two – managed internationalisation

In the second scenario, China never fully opens its capital account. In April 2015, former central bank governor Zhou Xiaochuan stated that China was seeking to adopt “a concept of managed convertibility.”8 Under managed convertibility, China might spur the creation of a new monetary system, in which renminbi use grows in the context of strong discretionary management.

Under this scenario, China could adopt a strategy of renminbi regionalisation, in which the currency serves as a reserve currency within an Asian trading bloc, involving some use of capital controls. The last sustained example of an international currency with major capital controls was the sterling bloc centred on the United Kingdom between the 1930s and the 1960s. While the sterling bloc was designed to manage and even hide British weakness, renminbi internationalisation would be designed to project China’s strength. Just like the sterling area, any renminbi bloc would be underpinned by a strong and complementary trading relationship, as well as geopolitical foundations.

Investment implications for scenario two

Under a scenario of Chinese regionalisation there will likely be a decline in risk premia in China’s trade partners due to a shift in the nature of China’s outbound investment. Investors should monitor signs of increasing regionalisation as reflected in Chinese policy initiatives like the Belt and Road and the expansion of the People’s Bank of China swap lines. Such regional initiatives could lead to a general decline in risk premia in emerging Asia and reduce the boom and bust of the dollar funding cycle. A relevant parallel is perhaps Western European involvement in Eastern Europe, which boosted overall investment and financial connections. The spread between nominal German and Hungarian 10-year bonds fell by 380 basis points in the 20 years to the first quarter of 2019, though the crisis in between also suggests that if unmanaged, the de-risking process can go too far.

The second broad impact to asset allocation is a transformation of Asian emerging market economic cycles. Dollar dominance is partly predicated on the fact that the dollar is still the default currency for trade, with 80% of dollar-denominated imports never entering the US. Economists have found strong invoicing effects from the dollar, where overseas economies’ trade, inflation rates and asset values exhibit great sensitivity to movements in the dollar. Increased invoicing in renminbi will cause other economies to trade more in line with China’s economic and financial cycles, boosting investment strategies that are related to this transformation.

3. A reduced role for the dollar

Scenario three – a reduced role for the dollar

Under the third scenario, other countries increasingly take steps to reduce use of the dollar in invoicing, trade, and finance, thereby setting off a chain of events that eventually erodes dollar dominance. As explored earlier, a dollar down cycle, geopolitical shifts, changes in energy market dynamics and structural shifts in China are already driving de-dollarisation. As these drivers gain momentum, currency multipolarity could become a reality. Depending on whether the euro and the renminbi have had time to internationalise, and can pick up the slack, a decline in dollar use could have a negative impact on global liquidity – just as the move away from the gold standard in the 1930s prompted a chaotic adjustment. By contrast, the 1971 collapse of the Bretton Woods system did not slow growth or undermine financial stability.

Nothing is foreordained. The quality of US policy-making has a material impact on how multipolarity manifests itself. If the US maintains strong economic fundamentals and institutional strength, then the development of plausible alternatives to the dollar could even be a net positive. It would signal strength in the global economy.

Nevertheless, the impact of a reduced role for the dollar would erode the exorbitant privilege of the US by increasing long-term US funding costs, reducing seigniorage revenue, exposing the US to more foreign economic shocks, and reducing US influence in the world – all of which would ultimately affect US living standards.

Investment implications for scenario three

Under the final scenario of a reduced role for the dollar, we do not envisage a single event but rather a continuum of possible futures, ranging from a brief period of realignment to a general and systemic crisis. Here we focus on the most favourable development – a realignment instigated by a gradual reallocation of reserves and commodities into non-US currencies.

In terms of asset allocation, a secular weakening of the dollar would amplify existing trends that are bearish for the dollar, including late-cycle market behaviour, an anticipated convergence in US and non-US rates, and an expected dollar down cycle. The key opportunity lies in understanding that the change may be secular rather than cyclical. Signs of a shift out of the dollar could signify greater downside for the dollar over the longer term.

While gold could benefit, we may also see an increased allocation to safe-haven currencies with twin surpluses, just like in the 1930s when reserve managers turned to countries still on the gold standard – Belgium, France, the Netherlands and Switzerland. Moreover, rising US disengagement in international affairs could also result in affected countries reallocating some of their dollar currency reserves and assets into the yen, euro and renminbi. Finally, persistent US dollar weakness could be positive for global trade and inflation.9

In conclusion

After nearly seven years of a dollar up cycle and a de-rating in emerging market assets, investors should be aware that the nature of the opportunity unfolding could be structural rather than purely cyclical. In 1985, the United States arguably crossed the Rubicon from being the currency of a leading world creditor to a major world debtor. The US net foreign debt position has only grown since then, thereby undermining the fundamental basis of the dollar’s status as the primary reserve currency.

In anticipating what now plays out, it is worth keeping in mind that the three scenarios above are not mutually exclusive. For instance, it is possible that full Chinese capital account liberalisation occurs during a period of a prolonged dollar decline. Ultimately, we think the most likely scenario is the second one, a managed internationalisation of the renminbi, and specifically a regionalisation among China’s close trading partners. That is a major geopolitical development that is likely to prompt a decline in risk premia across emerging Asia as well as a general transformation of economic cycles in the region. As such, it is likely to require a new approach to asset allocation, both globally and regionally.

This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contain statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein. All rights reserved. Issued by Investec Asset Management, March 2019.